A Time to Rethink International Payments?

A number of changes are coinciding to create an opportunity to re-think cross border payments. As the dominance of the US in world trade reduces, the logic of using the dollar as the world currency becomes less clear. At the same time, technology has evolved, allowing almost instant low cost domestic payments while international payments remain slow and expensive. The question today is what is the right model on which to base the future and how? Dr Warren Coats, a long time IMF staffer, raised this top during the recent Currency News Book Club on ‘Hostile Money: Currencies in Conflict’, in which he was a panellist, asking us to consider Special Drawing Rights (SDR). This article provides the background to his suggestion and thoughts on SDRs. The what and how of payments Paying for things by barter is not efficient. And so, what was used to pay for things progressed from barter to coins to paper certificates bestowing claims on more safely stored commodities. The establishment of a common unit of account allowed for common invoicing and pricing. The paper certificates stopped people having to move valuable metals around to settle their payments. But as trade moved beyond being in very limited geographical areas, the priority became how to use these paper certificates, banknotes, bank drafts and cheques efficiently. The costs and risks of repatriating a paper certificate over long distances led to the establishment of networks of banks that recognised each other and settled their payments on their accounts with one common (central) bank – correspondent bank accounts. Rather than settling each individual transaction, they generally consolidated their payments due to and due from each other and settled the net amounts due each day in what became known as clearing houses. Local hubs led to regional hubs creating the requirement for interbank fund markets. In the US the establishment of the Federal Reserve Bank system in 1913 replaced the regional clearing houses and central bank money, the balances held at the Federal Reserve, became the settlement asset. The challenge of cross border payments The development of payments has always been driven by technology and, just as cash replaced barter, so scanning cheques replaced physically clearing them and digitisation is allowing retail and wholesale electronic payments. The payment of a particular currency ultimately requires the transfer of claims on its issuer (transfer of deposit balances at the issuing central bank). The technology for doing so has become quite efficient for domestic payments. Cross border trade, though, appears to be stuck in the past due to the need to exchange one currency for another and the lack of confidence created by operating across legal systems. The legal side operates within contract law, the use of international agreements around shipping risk (Incoterms) and the jurisdiction of the World Trade Organisation. For payments, there are systems in place that allow settlement that does not involve the movement of actual currency, but international payments remain significantly slower and more expensive than domestic payments. Given that cross border payments generally involve the exchange of one currency for another, there has been the need to find a way to avoid having to have exchange markets for each currency for every other currency. Economic efficiency has resulted in a hub-and-spoke model similar to that used by airlines, in which a vehicle currency (the hub) connects all the other currencies. This role is predominantly played by the US dollar. Exchange rate instability adds to the risk and cost of international trade. The theory of comparative advantage that underpins trade is made less efficient, particularly when central banks intervene to manage their exchange rate to achieve a policy goal. A stable currency would also make investment and liquid assets more stable, encouraging borrowing and lending and cross border contracts.

A global currency? Theoretical economists argue for a single global currency, or reserve currency, settled on the books for the equivalent of an international central bank. In fact, this is not completely theoretical since the Bank for International Settlement already operates a similar role for intercentral bank settlements and the IMF, with its 189 members, operates a reserve currency between its members, known as Special Drawing Rights based on a basket of five stable globally traded currencies. SDRs are used by the International Telecommunications Union and the International Postal Union to settle the accounts of their members. In effect, these unions are already using SDRs as if they were their domestic currency to make full and final settlement instantaneously. The Gold Standard was used as a tool to stabilise exchange rates and to give citizens, investors and partner countries confidence in a currency. In its strict ‘currency board’ application, if people required more currency to be issued, the central bank would have to buy equivalent gold. If people returned their currency, gold would flow out of the central bank. Central banks had to control money creation whether cash or broad money (deposits at commercial banks). Unfortunately, gold is expensive to store and to move, it is limited in supply and so changes in requirement for it can create artificial demand that distorts its price. Although in the long term its price was relatively stable, in the short term its value fluctuated creating instability.

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